Sunday, January 24, 2010

Preparing For The Coming Waterfall

Now that we've laid out the background as to why investors need to re-assess tactics, we can finally move on to suggesting some options.  This is the hard part.  For one, every investor's risk tolerances and goals are unique.  Second,  factors such as age and exposure to other risks need to be taken into account.  Since we can't do this on an individual basis for Marko's Take, we'll take a "rules-of-thumb" approach using the general categories of risk:  "conservative", "moderate", "aggressive" and "very aggressive".

As a disclaimer, I'd like to say that I am NOT currently a registered investment advisor and am only offering an OPINION.  You should NOT rely solely on what I've written, but possibly use this in conjuction with YOUR registered advisor and/or other investment professional before adopting anything written here today.

For investors who might believe themselves to be conservative, the best approach, in my opinion would be to go to cash and wait the storm out, before making any further commitments.

Moderate investors have more options.  At at minimum, they should lighten on all long exposure.  My own rule-of-thumb would be to reduce investments by 50%, put the rest in cash and wait the storm out.

It starts to get tricky when we approach some sort of aggressive status.  I would still recommend a reduction of AT LEAST 50 % to all long positions, coupled with either a hedging strategy utilizing Exchange Traded Funds (ETFs) or Exchange Traded Notes (ETNs) to place some chips on the downside.  For Gold investors, the ETN which goes by the symbol DZZ would do quite nicely. It's a double-inverse play on the price of Gold with a leverage of 2.0. In other words, DZZ is designed to GAIN 2% for every 1% loss in the price of Gold on a daily basis.

Before I go further, it is extremely important to note that ETNs involve "counter-party" risk, and any use of them should be limited to the very short term and they should be scaled back if they indeed start to generate gains.  Unfortunately, if you begin to make decent money in an ETN, they get VERY volatile.  Therefore, I would view them entirely as a very short term play.  Diversify them, and take money "off the table" frequently.

For playing the downside in stocks, my personal view is the financial sector is in the greatest trouble AGAIN, and some very interesting ways of playing the waterfall exist. My personal favorites are FAZ, a triple-inverse ETN to the financial sector, or SKF, a double-inverse ETN. 

There also exist many ways to play the downside in various indicies like the Dow, Nasdaq, or Russell 2000 - an index of "small cap" stocks.  In waterfall situations, larger companies like those which make up the Dow or Nasdaq will normally perform better than the types of smaller companies which comprise the Russell. Therefore, I prefer to use TZA - another double-inverse play specifically designed to benefit from losses in the Russell 2000.

If you consider yourself very aggressive,  I would lighten up on all long exposure as much as possible and use some combination of the above mentioned ETNs to create a true downward playing portfolio.

Finally, we need to consider the "what if Marko is wrong again" scenario.  I believe that answer as to Gold is simple.  Use a material and sustained UPWARD breach of $1,100 as your guide.  I'd wait at least one day before taking action, and if such a breach does occur, I'll revisit Gold at that point.

As to stocks, I'd consider the 10,600 level of the Dow as my failsafe.  In other words, should the market suddenly reverse and rally upward through 10,600 then my cascading waterfall scenario would likely become null and void.  Again, should that occur or look like it might, I'll cover stocks.

Finally, it appears volatility is ready to jump and unless you have the stomache to deal with it, I'd sit this dance out.  The market may "bounce" on Monday, or it could "gap" lower, I have no idea.

I hope, after reading this, you're ready for Monday. 

Good luck!  If you have any questions, agree or disagree, you know what to do.  TAKE ME ON!

Marko's Take

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